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Reining in big banks? Try principles instead of rules.

Robert Reich was in town recently speaking at the Anchorage Economic Development Corporation annual economic forecast luncheon. I have to say AEDC does a great job getting world class speakers and provides helpful updates on economic trends in Anchorage -- among other things. I guess that’s why 1,300 people attended the lunch at the Dena’ina Center.

Reich is the former U.S. Secretary of Labor and is now an economics professor at the University of California at Berkeley. He is a man of the left and generally not my cup of tea, although he is good-natured and an entertaining speaker. The best line of the speech was when Reich offered up his definition of politics. It comes from the Greek “poli,” meaning many and “tics,” you know, blood sucking insects!

There is one thing I can agree with Professor Reich on and that is the need to break up the big banks. Reich noted that the former CEO of Citigroup, Sandy Weill, was on CNBC that morning and basically did a “mea culpa” admitting that the repeal of Glass-Steagall was a mistake. Recall, this was the 1933 law that was put in place after the Wall Street crash of 1929. It separated the riskier investment banking and trading from plain vanilla commercial banking -- deposit taking and loan making.

Glass-Steagall worked pretty well for over 60 years but was repealed in 1999 in part due to intense lobbying by Weill and others to allow Citibank and Travelers insurance (including the broker Salomon Brothers) to merge. The result was the first of several behemoth banks that have become too big to fail (TBTF). These are so large and so interconnected, that failure would cascade across the economy infecting other financial entities and ultimately the real economy.

The five largest U.S. banks had 16 percent of all bank deposits in 1994, 36 percent by 2007 just before the panic and are now at 43 percent. That’s right, despite the crisis and the Dodd-Frank bill passed to reign in the big banks; they are getting bigger and taking a greater share of deposits. They violate my golden rule: oligopoly bad, competition good.

I am not saying that the TBTF banks caused the financial crisis. In fact most of the troubled entities such as Bear Stearns, Lehman Brothers, AIG, Fannie Mae and Freddie Mac were not banks. They did play a part, but too much debt and a housing bubble fed by low interest rates and wide eyed optimism by homebuyers were also too blame.

It looks like Great Britain is moving to separate commercial banking from investment banking either directly or by establishing a firewall between two parts of the same holding company. Low-cost government insured deposits would not be allowed to fund risky trading but rather would go for traditional bank activities like making loans.

The British scheme is a step in the right direction but I’d still advocate for further downsizing the big commercial banks. When it comes to network-like risks I’d prefer the slight operating inefficiency of a bunch of midsized banks over the possibility of network failure owing to a few big hubs bringing the system down.

There is another problem. The Dodd-Frank legislation is 2,319 pages of “rules-based” law. The banks can always find themselves financial engineers, hot shot lawyers, sharp accountants or big time lobbyists to figure out ways around the specific rules. And the rules can’t anticipate everything in the complex and rapidly changing financial system.

So maybe a “principles-based” approach to regulation would do the trick. Writing in the New Yorker magazine, James Surowiecki compares our current system of rules-based regulations to a principals based approach noting:

“In a rules-based system, lawmakers and regulators try to prescribe in great detail exactly what companies must and must not do to meet their obligations to shareholders and clients. In principles-based systems, which are more common in the U.K. and elsewhere in Europe, regulators worry less about dotted i’s and crossed t’s, and instead evaluate companies’ behavior according to broad principles.”

Yes, a principles-based regulatory system would create uncertainty for financial institutions as to what are the specific rules. But maybe that’s good. Regulated entities would have to think about the spirit and intent of the law and not just the letter of the law. They would perhaps even have to ask is it the right thing to do. Perish the thought.

The views expressed here are the writer's own and are not necessarily endorsed by Alaska Dispatch. Alaska Dispatch welcomes a broad range of viewpoints. To submit a piece for consideration, e-mail commentary(at)alaskadispatch.com.